Fannie Mae and Freddie Mac

By Daniel Hartsoe and Tom Guo

Fannie Mae, created during the Great Depression, and Freddie Mac, created in 1970, are government sponsored enterprises (GSE). Both help to facilitate mortgage lending as they buy mortgages from banks. These two corporations, owned by stockholders, are regulated by Congress and have access to loans at lower rates than competing financial institutions. In addition, the ties the two corporations have to the federal government give them the implicit backing of the Treasury in the event of bankruptcy or financial trouble.
In the 1990’s, Congress pressed Fannie and Freddie to issue more mortgages to low-income families to increase the proportion of families that owned their own home. To do this, the companies, with Congress’s approval, dropped their capitalization ratio (the equivalent of their reserve ratio) to 2.5%, one-quarter of the standard rate for financial companies. This advantage allowed Fannie and Freddie to insure or hold half of all U.S. mortgages. More importantly to the companies, though, this exposed them to the collapse of the housing market. Through the first half of the decade, as housing prices rose to record heights, more families took out more risky mortgages. Convinced that housing prices, and thus the value of their house, would rise forever, as they had for years, and given the low interest rate of 1.25% of 2003 that rose very slowly through 2006, homeowners decided to buy more expensive houses with more risky mortgages. Since some mortgage rates are adjustable (and usually closely mimic the fed funds interest rate that the Fed influences), the interest rates on these mortgages rose higher and higher, and, as home prices started to fall, more homeowners defaulted on their mortgages and had their homes foreclosed. As the housing bubble burst, Fannie and Freddie experienced increased difficulty in paying off their debt to bondholders, and faced the prospect of bankruptcy. It was at this point in time that the Federal Government nationalized both corporations, absorbing their assets and liabilities into the federal budget.
Congress’s directive to Fannie and Freddie had far-reaching impacts on the U.S. housing market. The easy access to mortgages both Fannie and Freddie provided to low-income families (ordered by Congress) artificially lowered the price of houses for families, since these mortgages were backed with very little in down payments. The easy access to mortgages for these low-income buyers that normally would not have been able to afford a home boosted the percentage of families owning the home in which they lived from 64% to 69% between 1994 and 2004. This represents the quantity of housing demanded in the market. But instead of this increase in quantity demanded being a result of increased supply of housing, it was a consequence of increased demand for housing—an increase fueled chiefly by the availability of mortgages to families that otherwise could never dream of affording the house they now were able to buy. The surge in demand for houses led directly to the surge in house prices, the surge now known as the housing bubble. When the bubble burst just over a year ago, the families that couldn’t afford their mortgages any more, that had no steady source of income—the families Congress meant to help by ordering Fannie and Freddie to issue more mortgages at lower prices—were the first to lose their homes. Congress’s policies in the housing sector, specifically in the case of Fannie Mae and Freddie Mac, directly fueled the housing bubble and led to the financial crisis that plagues the economy today.

Sources:
http://www.bloomberg.com/apps/news?pid=20601109&refer=home&sid=a8vyq70TQcMM
http://online.wsj.com/article/SB122298982558700341.html